Sovereign Order n°7,334 of 1 February 2019, amending Sovereign Order n°3,152 of 19 March 1964 establishing a corporate income tax, recently introduced a new general capping mechanism for deductible financial expenses.
Financial expenses are treated as deductible costs for the purposes of calculating corporate income tax. They represent the interest on liabilities contracted by the business, whatever form they take.
In practice, financial expenses mainly consist of interest on bank loans or bond issues.
This mechanism, which applies to fiscal periods commencing on or after 1 January 2019, has replaced the so-called “smoothing” mechanism introduced by Sovereign Order n°4,335 of 13 June 2013, which resulted in Article 9-5 of Order n°3,152 of 19 March 1964. Prior to the reform of 2013, there was no upper limit on the deduction of financial expenses in the Principality, and so companies liable for corporate income tax were free to deduct these expenses from their taxable profit as they saw fit.
The “smoothing” mechanism required a portion of the financial expenses to be added back for companies liable for corporate income tax, wherever the total amount of net financial expenses relating to amounts left or made available to a company exceeded 3 million euros in one fiscal period.
Now, paragraph two of Article 9-5 of the Order of 1964 provides that net financial expenses may only be deducted from taxable net income up to the following limit (whichever is higher):
- 3 million euros per fiscal period;
- 30% of the company’s EBITDA.
The text also provides for a dual carry-forward mechanism:
- Any net financial expenses which do not qualify for deduction for the fiscal period may be carried forward indefinitely;
- Any unused deductions for a fiscal period may be carried forward for up to five fiscal periods.
As an exception to this, paragraph two of Article 9-5 of the Order of 1964 provides for the application of a cap on deduction of net financial expenses divided by three where the company is under-capitalised, i.e. where the average amount of sums left or made available by companies is more than one and a half times higher than its own equity.
In this case, the amount of net financial expenses the company is permitted to deduct will be limited to one of the following two amounts, whichever is higher:
Similarly, where a company is under-capitalised, the fraction of financial expenses not eligible for deduction for the fiscal period concerned may be deducted from subsequent periods only up to the limit of one third of its amount. Finally, no unused deductions may be carried forward.
With this change, the Principality is bringing its legislation into line with French tax rules on the deduction of financial expenses, and with Article 4 of the ATAD Directive of 12 July 2016, which aims to combat tax avoidance by certain companies through debt arrangements and under-capitalisation.